24 measuring the cost of living

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24

Measuring the Cost

of Living

Measuring the Cost of Living

• Inflation refers to a situation in which the Inflation

economy’s overall price level is rising

• The inflation rate is the percentage change in inflation rate

the price level from the previous period

THE CONSUMER PRICE INDEX

• The consumer price index (CPI) is a measure of

the overall cost of the goods and services

bought by a typical consumer

• The Bureau of Labor Statistics reports the CPI

each month

• It is used to monitor changes in the cost of

living over time

THE CONSUMER PRICE INDEX

• When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living

How the Consumer Price Index Is Calculated

• Fix the Basket: Determine what prices are most

important to the typical consumer

• The Bureau of Labor Statistics (BLS) identifies a

market basket of goods and services the typical

consumer buys

• The BLS conducts monthly consumer surveys to set

the weights for the prices of those goods and

services.

• Find the Prices: Find the prices of each of the

goods and services in the basket for each point

in time

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• Compute the Basket’s Cost: Use the data on

prices to calculate the cost of the basket of

goods and services at different times

• Choose a Base Year and Compute the Index:

• Designate one year as the base year, making it the benchmark against which other years are compared

• Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100

• Compute the inflation rate: The inflation rate

is the percentage change in the price index from

the preceding period

• The Inflation Rate

• The inflation rate is calculated as follows:

Inflation Rate in Year 2 =CPI in Year 2 - CPI in Year 1

CPI in Year 1 ×100

Table 1 Calculating the Consumer Price Index and the

Inflation Rate: An Example

Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example

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Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example

• Calculating the Consumer Price Index and the Inflation Rate: Another Example

• Base Year is 2002.

• Basket of goods in 2002 costs $1,200.

• The same basket in 2004 costs $1,236.

• CPI = ($1,236/$1,200) × 100 = 103.

• Prices increased 3 percent between 2002 and 2004.

FYI: What’s in the CPI’s Basket?

16%

Food and beverages

17%

Transportation

Medical care

6%

41%

Housing 6%

Education and

communication

Problems in Measuring the Cost of Living

• The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living

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• Substitution bias

• Introduction of new goods

• Unmeasured quality changes

• Substitution Bias

• The basket does not change to reflect consumer reaction to changes in relative prices.

• Consumers substitute toward goods that have become relatively less expensive.

• The index overstates the increase in cost of living by not considering consumer substitution.

• Introduction of New Goods

• The basket does not reflect the change in purchasing

power brought on by the introduction of new

products.

• New products result in greater variety, which in turn

makes each dollar more valuable.

• Consumers need fewer dollars to maintain any given

standard of living.

• Unmeasured Quality Changes

• If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same.

• If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same.

• The BLS tries to adjust the price for constant quality, but such differences are hard to measure.

• The substitution bias, introduction of new

goods, and unmeasured quality changes cause

the CPI to overstate the true cost of living

• The issue is important because many government

programs use the CPI to adjust for changes in the

overall level of prices.

• The CPI overstates inflation by about 1 percentage

point per year

The GDP Deflator versus the Consumer Price Index

• The GDP deflator is calculated as follows:

GDP deflator = Nominal GDP

Real GDP ×100

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The GDP Deflator versus the Consumer

Price Index

• The BLS calculates other prices indexes:

• The index for different regions within the country.

• The producer price index, which measures the cost

of a basket of goods and services bought by firms

rather than consumers

• Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising

• There are two important differences between the indexes that can cause them to diverge

The GDP Deflator versus the Consumer

Price Index

• The GDP deflator reflects the prices of all

goods and services produced domestically,

whereas

• …the consumer price index reflects the prices

of all goods and services bought by consumers.

• The consumer price index compares the price of

a fixed basket of goods and services to the price

of the basket in the base year (only occasionally does the BLS change the basket)

• …whereas the GDP deflator compares the price

of currently produced goods and services to the

price of the same goods and services in the base year

Figure 2 Two Measures of Inflation

Percent

per Year

15

CPI

GDP deflator

10

5

CORRECTING ECONOMIC VARIABLES FOR THE EFFECTS OF INFLATION

• Price indexes are used to correct for the effects

of inflation when comparing dollar figures from different times

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Dollar Figures from Different Times

• Do the following to convert (inflate) Babe

Ruth’s wages in 1931 to dollars in 2001:

Salary Salary Price level in 2001

Price level in 1931

= ×

=

$80,

$931,

000 177 152 579

Table 2 The Most Popular Movies of All Times, Inflation Adjusted

Indexation

• When some dollar amount is automatically

corrected for inflation by law or contract, the

amount is said to be indexed for inflation

Real and Nominal Interest Rates

• Interest represents a payment in the future for a transfer of money in the past

• The nominal interest rate is the interest rate

usually reported and not corrected for inflation

• It is the interest rate that a bank pays.

• The real interest rate is the nominal interest

rate that is corrected for the effects of inflation

• You borrowed $1,000 for one year

• Nominal interest rate was 15%

• During the year inflation was 10%

Real interest rate = Nominal interest rate –

Inflation

= 15% - 10% = 5%

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Figure 3 Real and Nominal Interest Rates

1965

Interest Rates

(percent

per year)

15

Real interest rate

10

5

0

–5

1970 1975 1980 1985 1990 1995 2000

Nominal interest rate

Summary

• The consumer price index shows the cost of a basket of goods and services relative to the cost

of the same basket in the base year

• The index is used to measure the overall level

of prices in the economy

• The percentage change in the CPI measures the inflation rate

Summary

• The consumer price index is an imperfect

measure of the cost of living for the following

three reasons: substitution bias, the

introduction of new goods, and unmeasured

changes in quality

• Because of measurement problems, the CPI

overstates annual inflation by about 1

percentage point

Summary

• The GDP deflator differs from the CPI because

it includes goods and services produced rather than goods and services consumed

• In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes

Summary

• Dollar figures from different points in time do

not represent a valid comparison of purchasing

power

• Various laws and private contracts use price

indexes to correct for the effects of inflation

• The real interest rate equals the nominal interest

rate minus the rate of inflation

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